We're big fans of ETFs at ETFstream. ETFs enable people to invest in stocks - and other assets - cheaply and simply. But ETFs aren't perfect, and there are pitfalls you can fall into if you're not careful.
So let's take a look at the major ETF pitfalls and how you can avoid them.
Trading too much
One of the big plus points for ETFs is that you can trade them immediately - as long as you're within stock market trading hours. You can also trade them as often as you like. Just like shares in companies. By contrast, with a conventional unit trust or OEIC, you can only trade once a day. What's more, you have to wait until that fund's daily trading point to find out the price at which you're buying or selling.
The pitfall with ETFs is that you may be tempted to trade up. Every time you buy or sell an ETF, you have to pay a trading fee and those fees can mount up quickly if you trade too often. You're much more likely to do well as an investor if you keep your costs down and focus on the long-term. There's a lot to be said for building a portfolio and then leaving it untouched for five years or more.
What's more, you may well find that selling out of ETF A and putting the money into ETF B doesn't improve your investment performance one jot. I've traded far too much in my investment career and I've often traded out of a share or ETF that proceeded to perform better post-sale than its replacement ETF in my portfolio.
To avoid this pitfall, you need to be self-disciplined. You could introduce a rule that when you invest in an ETF, you can't sell out for at least five years. Or you could allow yourself, say, three trades a year for your whole portfolio. Or just be really tough with yourself every time you're tempted to press the 'sell' button. Can you make a really strong, almost watertight, argument for selling? If not, stay put and don't sell.
Paying too much
Another way to keep your costs down is to pay as little as possible when you do trade. Most private investors invest in ETFs via online stockbrokers such as Hargreaves Lansdown and The Share Centre. (These brokers are also known as 'platforms' or 'fund supermarkets.') But investors may not realise that some brokers charge a lot more than others. Don't assume that the brokers with the biggest marketing budgets offer the best deals. It's easy to end up paying more than you need to.
Picking the cheapest broker is harder than you might think. That's because the choice depends on your individual circumstances. Some brokers offer their best deals to investors with big portfolios, others to frequent traders. Some brokers also charge a monthly 'platform fee.' You can find out more about the cheapest brokers here.
It's also worth noting that some brokers charge lower trading fees for conventional unit trusts and OEICs than for ETFs. Or sometimes no fee at all. If you're with one of these brokers, it's all the more reason to make sure that you don't trade too much with your ETFs.
Be careful with regular investing
Regular investing is normally seen as a good thing. If you invest a set amount from your pay packet each month, you should gradually build up a nice nest egg. But there is a pitfall with regular investing via an ETF. If you invest, say, ¬£200 each month, you could end up paying too much in trading fees. That's because some brokers charge minimum trading fees that can be as high as ¬£12.50 a time. That's a big chunk of your ¬£200 going on fees.
If you want to do regular investing, you need to go with one of the brokers that offers special rates for regular investors. Interactive Investor, for example, charges just ¬£1 a trade for regular investors.
Don't just focus on fund charges
Fund charges aren't the only cost to think about. An ETF's spread is also important. The spread is the difference between the bid (buy) and offer (sell) price. If the spread is large, that's an extra cost for investors. A fund with a really low annual charge may also have a relatively big spread.
If you're torn between two or more ETFs for your investment cash, have a look at the spreads over a few days or weeks and get a feel for which one has the tightest spread and is therefore the least costly.
It's sometimes the case that ETFs with more money under management have tighter spreads, but it's not always the case.
Don't assume all ETFs are cheap
There are plenty of ETFs with very low charges. You can read about some the cheapest in
. But don't assume that all ETFs have low charges. For example, the Xtrackers S&P Select Frontier Swap UCITS ETF 1C charges 0.95% a year. (This ETF invests in 'frontier markets' such as Kuwait and Cambodia.)
The cheapest ETFs tend to be the 'plain vanilla' ones that track well-known indices such as the UK's FTSE 100 and S&P 500 in the US. ETFs that track more esoteric assets such as the Chilean stock market, or corporate bonds tend to charge more. Smart beta ETFs also tend to be more expensive.
The lure of leverage
If you're convinced that Japanese shares are going to go up, a Japan ETF that offers 2x returns sounds great. The idea behind is that if the Japanese stock market rises 10%, your leveraged 2x returns Japan ETF should deliver a 20% return.
There are two big pitfalls here though. Firstly, although the potential returns are higher, the risk is higher too - if the Japanese stock market falls 10%, the ETF will fall 20%.
Secondly, these ETFs rebalance daily which creates a big problem. Let's imagine the 2x Japan ETF has a share price of ¬£1. It tracks the Nikkei 225, and the Nikkei falls 5% one day. So the share price falls by 10% to 90p.
On day two, the Nikkei retraces most of its fall and rises by 5%. So the ETF will rise by 10% and go to 99p, down 1% for the two days. But the Nikkei's two-day return would be just -0.25%, a fall that is four time smaller than the ETF's. As the days and weeks go by, the divergence between the performance of the index and the performance of the ETF will grow. Because of this divergence, it only makes sense to use leveraged ETFs for short periods - days or weeks at most.
Unless you want to be a short-term trader, and you're good at it, it's best to steer clear of leveraged ETFs. The same is true of Inverse ETFs that provide positive ETFs when the underlying asset falls in value. These inverse ETFs also rebalance daily.
Big stock bias
There's a lot to be said for simplicity in investing. If that's your bag, you might be tempted to put all your money into just two ETFs. Perhaps one ETF tracking the FTSE 100 and the other tracking the S&P. It wouldn't be such a dumb strategy, but there would be one downside. A bias towards larger companies, or large caps. That bias is a problem because over the very long term, smaller companies tend to perform better than their larger stock market brethren.
It's not just that the FTSE 100 comprises only the 100 largest companies on the UK stock market. On top of that, the ten largest companies make up about 40% of the value of the FTSE 100. So your investment would be heavily weighted towards the Footsie's biggest stocks such as GlaxoSmithKline and Shell.
I'm not suggesting that you should only invest in smaller companies. Far from it. But it makes sense to have some exposure to smaller companies. It's best to get some larger company exposure with a FTSE 100 ETF or something similar, and then for smaller companies, you could go for one or two of the smaller company ETFs that are out there. Or you might prefer to invest in some smaller companies investment trusts where you have active fund managers picking stocks for you. With smaller companies, there's a bigger opportunity for active fund managers to find undiscovered bargains.
As I said at the beginning, we love ETFs here. Hopefully being aware of these pitfalls will improve your investment performance and make you a big ETF fan too!